What Is Fiat Money?

The history of mankind is the history of money losing value.
Milton Friedman

We saw in the previous module how money evolved over time and how our monetary system transitioned from sound to unsound money, shaping the world we live in today. This module dives deeper into how these developments led to today's fiat system and how that fiat system works.

So how did the fiat system we use today come into existence?

To understand it, we need to look at the US dollar. Today, the dollar serves as the world’s main reserve currency, meaning many countries rely on it for trade, savings, and financial stability. Because of this, decisions about the US dollar affect economies all around the world.

To understand how money works in your country, it helps to understand how the modern fiat system developed in the United States.

In the 19th century, many societies used a sound money system based on precious metals like gold and silver. These metals were valued because they were scarce, durable, and widely recognized. As trade increased, carrying large amounts of metal became inconvenient. Banks began storing gold and silver for people and issuing paper certificates that represented the exact amount of metal deposited.

Over time, banks started issuing more paper certificates than the gold they actually held. This practice, known as fractional reserve banking, created the risk of bank runs, where many people tried to withdraw their gold at the same time. To stabilize the banking system, governments became more involved.

In 1913, the United States created the Federal Reserve, a central bank that could issue new money and support struggling banks.

During the 1930s, the U.S. government also required citizens to surrender their gold in exchange for paper dollars. Soon after, the government reduced the dollar’s value relative to gold, which decreased the purchasing power of people’s savings.

After World War II, the Bretton Woods system linked global currencies to the U.S. dollar, and the dollar could still be exchanged for gold. This system ended in 1971, when the United States stopped allowing dollars to be redeemed for gold. Since then, most countries use fiat money.

Fiat money is currency that is not backed by a physical commodity like gold. Instead, it has value because governments declare it legal tender and people accept it for payments.

The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust.
Satoshi Nakamoto

Humanity transitioned from sound money controlled by the many to unsound money controlled by the few. But how does this system work exactly?

A Monetary System by Decree

The fiat system is characterized by its mandatory nature, being imposed on people through legal tender laws. The Latin term fiat means “by decree” and thus refers to a directive issued by some authority.

Unlike money backed by tangible assets such as gold, fiat derives its value from its enforced monopolistic position and the public’s trust in the monetary and financial system. In that sense, fiat money is comparable to a concert ticket: its value lies not in the paper ticket itself, but in the assurance that the band (the government and its central bank) will deliver a great show (provide economic stability).

All major currencies like dollars, euros, pounds, yuans, pesos and others fall under the category of fiat money.

Legal tender law: a law making it obligatory for all citizens to accept a specific kind of currency.

Pros of Fiat Money

• Ease of use: Fiat money is convenient for everyday transactions.
• Lower costs and risks: Fiat money doesn’t require heavy security like gold, making it cheaper and safer.

Cons of Fiat Money

• Inflation risks: Governments can print fiat money at will, devaluing the currency and causing prices to rise, which decreases the purchasing power of savers. In some historical cases, such abuse has led to instances of hyperinflation.
• Centralized control and manipulation: Small groups can influence and manipulate the system, leading to politically motivated debanking and confiscation.
• Counterparty risk: If the government faces challenges, and the public loses trust, the currency can lose value.

Before fiat currency came about, governments would mint coins out of valuable and scarce physical commodities such as gold or silver, or they would print paper money that could be redeemed for a fixed amount of those commodities. This is known as a commodity-backed system.

In the fiat system, it is more like having Monopoly money. Fiat money consists of paper issued by the central bank, and its value is influenced by government policy. The government and central banks act like the “bankers” of the Monopoly game: they control how the system works, who gets what, and how much money is worth. In other words, the value of fiat money depends on trust in the government to manage the monetary system responsibly.

The fiat system is a trust game in which the value of our money rests on the promises of those in charge and where people can only hope that their government acts for the benefit of all.

A System Fueled by Debt

It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.
Henry Ford

Fractional reserve banking is a key element in the fiat system. It means that banks are legally allowed to lend out a significant portion of their clients’ deposits, so that at any given time the bank actually holds only a tiny percentage of the money their clients think they have deposited there. Have you ever wondered why banks offer so many services to their customers beyond just securing their deposits? While it may seem like they are being generous, it’s important to remember that banks are businesses and their primary goal is to make a profit. But how do they make a profit if they let people borrow money?

Banks generate revenue in many ways

• Charging interest on loans they give out.
• Charging fees for services like ATM usage and account maintenance.
• Earning money through investments, like buying and selling securities or investing in real estate.
• Keeping a percentage of loans in reserve and investing or lending out the rest.
• Paying interest on deposits and charging fees on checking and savings accounts.
• When a bank receives a deposit, it is required to hold onto only a fraction (the reserve requirement) and is legally allowed to lend out the remaining portion.

This process leads to a debt-driven monetary system as banks create new currency with each loan, increasing the overall money supply. As fractional reserve banking continues, the total debt in the economy rises, contributing to inflation. The system relies on a continuous cycle of currency creation through lending, akin to a steady supply of drugs for an addict: as long as everyone keeps playing, the illusion holds. If, however, banks get too greedy with their lending practices and people lose trust in the banking system, the whole system can quickly collapse onto itself.

This is where the central bank comes in as a lender of last resort, providing new currency to prevent bank failures and keep the illusion going. The central bank achieves this by repurchasing assets or injecting currency directly into banks’ balances. In essence, banks are rescued from failure through the constant injection of new currency by central banks, resulting in boom-and-bust cycles.

1. Banks borrow money from depositors at an interest rate (let’s say 5%)
2. Banks lend this money to borrowers at a higher interest rate (let’s say 9%)
3. Banks pay interest from interest received by lending (9% - 5% = 4%) and keep the rest as profit

How Banks Create Money

Commercial banks create new fiat money when they issue loans.

1. Boom
   • Money supply expands as banks create new loans
   • People and businesses borrow and spend more
   • Demand increases and prices rise
   • Investments increase, often beyond what the real economy can support
2. Bust
   • Demand slows and investments begin to fail
   • Asset prices fall
   • Borrowers struggle to repay their loans
   • Banks face losses as collateral loses value
3. Central bank intervention
   • Central banks create new money to support banks and the financial system
4. Cycle repeats
   • Credit expands again, starting a new boom phase

The Imaginary Bikes

Imagine you have a bike and lend it to a banker. Instead of simply using it, the banker starts promising the same bike to many other people at the same time. Each person believes they can use the bike whenever they want. But in reality, there is still only one bike. All the other bikes are just promises.

At first, everything seems fine. Not everyone wants to ride the bike at the same time, so people believe there are plenty of bikes available. Because of this, everyone feels confident and keeps making plans.

But one day, everyone decides they want to ride at the same time. They all show up expecting their bike, and suddenly the problem becomes clear: there is only one real bike. Most people cannot get what they were promised.

Modern banking works in a similar way. Banks keep only a small portion of the money people deposit and lend the rest to others. This means banks create many more claims to money than the actual money they hold.

Most of the time this system works because people do not withdraw their money at the same time. But if many people try to withdraw their money at once, the bank cannot fulfill all those promises. This is called a bank run.

When this happens, the financial system can become unstable, and the people who often suffer the most are those with the least financial protection.

Who Controls the Fiat System?

The Government

The government is like the director of the fiat show. Along with tax collection, it is funded through new debt (bonds) issued by the Treasury. When there is insufficient demand for these bonds, any remaining debt is purchased by the central bank. This means they can keep increasing government spending without angering people by raising taxes. This might seem good for the government, but it comes at a cost for everyone else: it’s like getting a credit card where someone else foots the bill. Government debt is just a promise to tax the people more in the future.

Wealthy Individuals

They also benefit a lot from the fiat system. Because their savings are mostly held in assets, their purchasing power actually increases as the currency (the unit of account) loses value. In addition, they use their appreciating assets as collateral to accumulate cheap debt which they further invest in assets. Since they are “closer to the money printer,” they barely feel the consequences of currency depreciation.

Financial Sector (banks)

Banks and other financial institutions do not directly control the fiat system but greatly benefit from it. Thanks to the existence of a central bank, which will bail the banks out to prevent the whole system from collapsing, they are virtually free from consequences and are thus incentivized to aggressively pursue higher profits via increasingly risky fractional reserve lending. This is the basis of the boom-and-bust cycle that we discussed earlier.

The Central Bank

They also benefit a lot from the fiat system. Because their savings are mostly held in assets, their purchasing power actually increases as the currency (the unit of account) loses value. In addition, they use their appreciating assets as collateral to accumulate cheap debt which they further invest in assets. Since they are “closer to the money printer,” they barely feel the consequences of currency depreciation.

How they benefit

These groups benefit in various ways, creating a complex web of control and influence. The government gets access to funding and delays the need to be fiscally responsible, wealthy individuals and banks make their profit effortlessly, and the central bank keeps the show running while feigning independence. Meanwhile, the rest of the population bears the brunt of the whole scheme, as their cash savings slowly melt year after year.

In the end, the fiat system's puppeteers orchestrate a show where a few benefit greatly at the expense of the many, who are left to wonder how they will ever catch up.

The Role of Central Banks

Central banks quietly shape how an economy works. Their official job is to ensure stability and integrity, but their methods reveal a more sinister side.

Central banks work closely with governments and pull the strings of monetary policy, controlling the money supply with tools like interest rates. In times of crisis, they print money out of thin air and inject it into the economy through commercial banks, making it seem like everything is okay.

They’re not just neutral overseers; central banks regulate commercial banks, set the rules of the game, and step in to rescue them when they are in trouble acting as lenders of last resort. This web of control, while appearing protective, makes the economy and banks even more dependent on them.

Understanding where trillions of dollars in stimulus funds come from and who gets to decide how they are allocated is critical for comprehending the broader financial system. Governments use several tools to manage the money supply at specific moments in time.

Central banks and governments can use monetary and fiscal policy tools to influence the money supply and the economy. For example, the United States Federal Reserve (the Fed) uses monetary policy to adjust interest rates, affecting the amount of money in circulation. Fiscal policy, on the other hand, involves using spending and taxation to influence economic activity.

Target Rates Monetary Policy

• Unemployment Below 6.5%
• 2% - 3% Annual Increase in Gross Domestic Product
• Core Inflation Rate between 2.0% - 2.5%

Expansionary Fiscal Policy

• Aims to increase consumer spending and business investment to increase aggregate demand and economic growth.
• Increase Government Spending
• Lower Taxes

Contractionary Fiscal Policy

• Aims to decrease consumer spending and business investment to slow down unsustainable economic growth and prevent or reduce high inflation.
• Decrease Government Spending
• Increase Taxes

Exchange rate policies, supply shocks, and price controls serve as additional tools to regulate the money supply and impact trade and the economy. While these policies aim in theory to stabilize prices and control inflation, the intervention often leads to boom-and-bust cycles, which wipe out many businesses and the savings of many families.

Knowing how these policies function is vital for understanding the limitations of centralized fiat monetary systems. Until you understand the problem, you won’t recognize the solution.

Activity: Fractional Reserve Banking

This is a class exercise exploring individual actions by people and banks using the practice of fractional reserve banking. The intent is to experience firsthand how this tool increases the money supply.

Key Points

1. A fraction = part of a whole.
2. Fractional reserve banking is a tool banks use to lend more than they keep on-hand, or “in reserve”
3. The smaller the reserve amount, the more risk banks face in terms of bank runs or default.
4. This tool can be used with sound money (like gold) or with unsound money (like fiat).
5. The ability to expand the money supply, combined with bailouts and insurance programs, such as the FDIC, leads to moral hazard for banks. They have an incentive to make riskier decisions because they keep the profits, but their losses are paid by everyone.

Student Tip

You do not need to be a math expert to understand the main concept of reserve banking or its risks.

Central Bank Digital Currencies (CBDCs) are the next step of fiat currencies. Rather than a combination of physical bills, coins, and digital payments, CBDCs are fully digital forms of fiat currencies issued by governments and controlled by central banks.

Imagine the currency you use every day, but without any physical presence — no coins to jingle in your pocket or bills to fold. What sets CBDCs apart is the heightened level of control and monitoring they offer to governments and central banks. With CBDCs, authorities gain unprecedented visibility into financial transactions, making it easier for them to track, regulate and restrict the flow of money.

Governments and central banks can readily adjust the form and supply of CBDCs, manipulate interest rates, and deploy monetary and fiscal policy tools with greater precision. In essence, CBDCs provide a more efficient means for authorities to influence and manage their fiat currency.

While CBDCs seem to be the future of fiat money, the world's current monetary system already operates on a pure fiat standard. Fiat currencies are no longer tied to gold, resulting in a significant expansion of the monetary supply without any real restriction.